How Stocks are Priced

So what determines the price of a stock?  If a stock’s earnings are predictably growing and a stock will be making 20% higher earnings four years later, why doesn’t the stock just increase in value by 20% immediately?  As I’ve said before, one cannot take advantage of news for near-term trading because as soon as the news is released, it is already priced into the stock.  So why is this not true of the long-term.

The reason is that the future earnings, while often predictable, are not known for certain.  There is risk and uncertainty involved.  When one buys a stock, while one may believe that the earnings will increase and the stock price increase accordingly (because the stock would then be able to pay a bigger dividend), one does not know for certain.  It is not like putting money in a bank account with a fixed interest rate.  In the case of the bank, the interest will almost certainly be paid.  If it isn’t, one can sue the bank or the Federal Government may even make the payment.  With stocks, one cannot sue if earnings do not grow as expected, or even if the stock price drops and one loses money.

The rate of return of any asset, be it a bank account, bond, stock, or real estate will be based on the risk involved.  The more risk involved, the greater return individuals will expect to receive before they will take the risk.  Because bank accounts offer a way to safely store money, individuals will put money in even though they lose a couple of percentage points to inflation each year.  Before a person will buy a stock, the possible return, measured by dividends paid currently and price appreciation potential, must be large enough to justify the risk.  If stocks did not return several percentage points better than a bank account, why would anyone not just keep their money in the bank for the certain return?  They wouldn’t!

So, the price of a stock is based upon current earnings and current dividends (if any are paid), earnings growth rate (how large a dividend is likely to be paid in the future), and the perceived level of risk to the share price due to various factors and the predictability of the earnings growth.  If the predicted earnings growth rate for a stock is about 10% and there is good certainty that the company will meet expected earnings, the price of the stock may increase until the effective rate of return for new investors in the stock (based on predicted earnings) is about 8% per year if bank account interest rates are around 2%.  This means that investors are willing to take the increased risk of investing in the stock as long as they get at least 6% better return then they would get in the bank.  If bank interest rates increase, the price of the stock would drop until the rate of return was again about 6% greater than that of the bank.

If uncertainty of earnings increased, for example if a stock that had been producing steadily growing earnings entered a period where earnings were unpredictable, the stock price would drop until the rate of return was higher, perhaps 8% or 10% higher than that of a bank account.  Because an investor in the company now is less likely to actually get the 6% return, he will not invest unless the stock price is low enough that he will receive 8% if things do work out.  Note that this is why companies see the price of their shares drop when uncertainty increased, such as when Congress is proposing legislation that may affect their business or a lawsuit is pending.  The uncertainty makes it more difficult to predict future earnings, so people expect a higher possible return.  When the event actually happens, even if it ends up being detrimental to the company, the price usually increased when the news comes out because the uncertainty has been erased and investors can start to more easily predict future earnings.

So, this all means that if one picks companies that have fairly reliable long-term earnings growth trends, one can expect to generate a good investment return.  Even though the fact that earnings will probably grow is known by everyone, the full effect of the future earnings is not instantly priced into the price of the shares, as it is with near-term investing.  So, a serious investor, who really wants to make money, will take the long-term road.  The person who jumps in and out of stocks is just playing around and eventually the odds will catch up with him.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Stock Picking – Consistent Earnings Growth

As said in previous posts, finding stocks that will do well over the next day or week is difficult.  Even finding stocks that will do well over the next month or so is difficult.  The reason is that any news that will affect the stock price in the near term is already priced into the shares.  Whether the stock will go up or down is really a matter of luck since the short-term behavior of the stock will be somewhat random (although our minds will always try to find patterns, even if none exist).

In the long-term, however, prices can be predicted (at least the odds can be placed largely in our favor) for stocks that have predictable growth patterns.  Companies that have increased earnings at a sustainable and relatively reliable rate can generally be expected to continue to do so unless something dramatically changes about the way they do business or they run out of room to grow.  Note the important caveats that the growth rate must be reliable and sustainable.  It must be reliable in that earnings grow consistently rather than cycle between really good and really bad.  The rate must be sustainable because extremely large growth rates (say 40% per year) cannot continue more than a few years.  Because stock price growth tends to follow earnings growth — e.g. if a stocks earnings are increasing at 10% per year the average stock price will tend to increase at about 10% per year — if stocks can be found that have consistent earnings growth, it can be expected that the price of these stocks will increase at the same rate.

So why is it that there will be no price differential for events that happen in the near-term, such as earnings surprises, but there will be in the long-term?  It is not because everyone does not have access to the earnings predictions — they are widely available.  It is not that others can’t pick out stocks that have consistent earnings growth — they can, and stocks that have this property tend to command a premium and have P/E ratios that are higher than their peers.  The reason has to do with how stocks are priced relative to other investments, which is based primarily on the projected rate of return and the risk involved.  I’ll cover both aspects in future posts.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

Why the Stimulus Bill Won’t Work and How Wealth and Jobs are Created

Today I’d like to take an aside from investment strategy and philosophy and talk about the related topic of how wealth is created and the economy grows.  This is useful to understand to see why the economy is not growing, despite the large amounts of money put into stimulus by the government.

Since the 1930’s when British economist  John Maynard Keynes proposed his theories for economic stimulus, governments have been trying to spur economic growth through government spending.  Keynes reasoned that sometimes, when the private economy was unwilling to spend, the government can cause economic growth by spending more.  The government could buy things and provide work — even if it was just busy work — when the economy was flagging.  This would cause people to start spending money and buying things, which would have a multiplying effect.  For example, since the $10 paid to Sam would be used to buy a sandwich from Jim, who would use it to buy a gallon of gas from Larry, and so on, that $10 paid to Sam would be like $50 or $100.  Once things got rolling and businesses started spending again, the theory said, the government could then scale back their spending, collecting taxes to pay for the moneys borrowed during the slow period.

In order for the economy to truly expand, wealth must be created.  The trouble with Keynesian theory is that wealth is not created; therefore, no real lasting stimulus can result.  To understand why, let’s look at how wealth expands.

Wealth is a measure of the value of things in existence.  The value of things in existence is increased when 1)resources are found and available for use, 2)labor and/or thought is expended to add value to something and make it more useful, or 3)an increase in value is assigned to something by enough people.  The value of things decreases when 1)resources are used up, 2)things which were given value are consumed, or 3)the perceived value of something decreases. 

An example of value creation under the first category is when new oil deposits are found, trees are grown, or land is made available (when America was discovered).  Value is destroyed under category one when resources are used or destroyed, such as when oil is burned or land is reclaimed by the ocean.  Note that value is only created when resources are available for use.  A large pool of oil that no one can get to has little or no value, and it increases or decreases in value as demand for oil increases or decreases.

An example of value creation under category two  would be when a craftsman makes a table, an artist creates a work of art, or a worker takes iron ore and creates pig iron out of it.  Through their labor, people have increased the value of the raw materials, thus adding to the value of things in existence.  An example of using one’s mind to create value is when one devises a new way of using things, such as when silicon chips were invented.  This invention increased the value of silicon (sand), such that silicon deposits suddenly became more valuable.  This type of value is destroyed when the things created become obsolete or are worn out.  Note that performing services, like mowing a lawn, results in no net increase in value because the thing created is destroyed almost instantly, such that wealth is only transferred from the person wanting the service to the person providing it (in the form of money paid for the service).

The third category applies to things such as collector items, fads, and other such things.  Beanie babies became very valuable, such that people were willing to trade labor and materials for them.  This type of value creation tends to be short-lived, however, and is destroyed when people stop assigning the increased value to the items.  Many things in this category eventually lose their value just as Beanie Babies did.

Once wealth is created it can be traded, with currency often being used since money has an implied ability to obtain goods and services.  Money is also a form of wealth, although its value is destroyed if more money is printed.  For example, if a person has $20 and he gets a haircut from a barber, the net result is that $20 is transferred from the customer to the barber.  The customer has a haircut that has value for some time, but in the end the net amount of wealth is fixed at $20.  If a craftsman makes a good quality chair that will last for generations, however, and sells it to the barber for the $20, there is now a new wealth of $40 — $20 in cash and a chair worth $20.  The economy has now expanded.

When the government spends money, no net wealth is created.  This is because the government simply takes money out of the economy, destroys some creating paperwork and holding meetings that are of no lasting value, and then places a lessor amount back into the economy.  To see this, let’s say that John owns a car dealership.  The government taxes John $20,000, spends $2000 in paper work, and then distributes $18,000 to Fred in an effort to spur the economy, who then buys a car from John.  While it is true that John would not have had that car sale to Fred if the government had not given Fred the money to buy the car, the money used to buy the car came out of John’s pocket and some value was destroyed in the process.  If value were actually created, John would be better off simply giving a car to Fred and keeping the extra $2000!

Some stimulus can be created if the government borrows money, since then creation of value in the future is borrowed against to create wealth that can be used today.  The only issue is that because people know the loan will eventually need to be repaid, which will cause a slowdown in the economy, the effect is not as great as it would be if value were actually being created.   Once the government stops borrowing money and starts extracting value from the economy again, the economy will slow and be in the same condition as it was before the deficit spending was done.  In fact, the economy may need to contract to reset itself to equal the amount of wealth actually in existence.